This site uses cookies to store information on your computer. Some are essential to make our site work; others help us improve the user experience. By using the site, you consent to the placement of these cookies. Read our privacy policy to learn more.

Ten Things to Know About the Roth 401(k)

Since
the introduction of the Roth IRA in 1997, it has become a popular
retirement vehicle. However, the contribution limits for the Roth
IRA have been relatively low and, due to participant income
limitations, not everyone has been able take advantage of the Roth
designation. The Economic Growth and Tax Relief Reconciliation Act
of 2001, P.L. 107-16 (EGTRRA), added Sec. 402A, which provides for
designating Roth contributions. Effective January 1, 2006, many
individuals previously excluded can now take advantage of the
tax-free growth of Roth contributions by means of the Roth 401(k).
The Roth 401(k) is not a new plan but a feature for designating
deferrals as Roth contributions.

Amendments to the
regulations under Secs. 401(k) and (m) provide guidance on
designating Roth contributions under Sec. 402A. Initially, Sec.
402A was to sunset on December 31, 2010, but the Pension
Protection Act of 2006, P.L. 109-280, made the changes under
EGTRRA permanent. This item explains ten things taxpayers should
be aware of when considering a Roth 401(k). (For an in-depth
discussion of the Roth 401(k) rules, see Beausejour and Lynch, “An
Analysis of the New Roth 401(k)/403(b) Plans,” 39 The Tax
Adviser 515 (August 2008).)

1. Applicable Plans

The Roth 401(k) is a feature that can be added to a new or existing
company-sponsored defined-contribution pension plan, including (1) a
plan qualified under Sec. 401(a), which includes a traditional
401(k) and a safe-harbor 401(k); and (2) a 403(b) tax-sheltered
annuity arrangement (Sec. 402A(e)(1)). The Roth feature is not
allowed in a SARSEP or a SIMPLE IRA plan because they are not
applicable retirement plans under Sec. 402A(e)(1). Employees elect
to designate a portion or all of their elective contributions as
Roth contributions (Sec. 402A(b)(1)).

2. Rules for Roth

Contributions are included in gross income at the time the employee
would have received the contribution amounts in cash if the employee
had not made the cash or deferred election. Earnings on the account
accumulate tax free and, if the distribution is qualified, the
distribution is tax free. Therefore, as long as all distributions
from an account are qualified distributions, the earnings on the
Roth 401(k) funds are never taxed (per Sec. 402A(d)(1)).

3.
Qualified and Early Distributions

A qualified distribution is
one that occurs at least five years after the year of the
participant’s first designated Roth contribution (counting such
first year as part of the five) and is made on or after the
participant reaches age 59½, because of the participant’s
disability, or on or after the participant’s death (Sec.
402A(d)(2)). Sec. 402A does not provide a specific ordering rule
regarding unqualified distributions from designated Roth accounts,
so Sec. 72 applies to determine the character of distributions from
such accounts (Regs. Sec. 1.402A-1, Q&A-3).

4. Funds
Designated Irrevocably

Roth contributions are designated
irrevocably, so once the designation is made, there is no reversing
it (Regs. Sec. 1.401(k)-1(f)(1)(i)). However, the employee must have
an opportunity to make or change future elections at least once
during a plan year (Regs. Sec. 1.401(k)-1(e)(2)(ii)).

5. Plan
Must Also Offer Pretax Elective Contributions

A plan cannot
allow for only Roth contributions; it must also allow for the
traditional, pretax elective deferrals (Regs. Sec. 1.401(k)-1(f)).
This means that many forms used in the plan’s administration will
need to be modified to accommodate both features.

6. Contribution
Elections

An individual may make both traditional pretax and
Roth designated contributions in a plan year. In 2008, an individual
has an aggregate elective contribution limit of $15,500 for all
designated Roth contributions and traditional pretax contributions,
with an additional $5,000 if the participant is age 50 or over
(Notice 2006-98). The maximum employee and employer annual
contribution is the lesser of $46,000 or 100% of compensation. Under
Sec. 402A(c)(2), if, for example, an individual chooses to designate
$12,000 as Roth contributions, he or she may designate the remaining
$3,500 (or $8,500, if over age 50) as traditional pretax
contributions. Any additional contributions over the $15,500 (or
$20,500) limit up to $46,000 will be treated as after-tax
contributions (included in income), and the earnings will be tax
deferred.

7. Matching Contributions Are Not Roth

Employers may match Roth contributions, but these contributions may
not be added to the Roth account (Regs. Sec. 1.401(k)-1(f)(2)).
Rather, the employer match will be with pretax moneys and must be
kept in a separate account. Whereas the employee Roth contributions
may be withdrawn tax free, the employer-matched moneys, like any
pre-tax contribution to a 401(k) account, will be treated as
ordinary income at withdrawal.

8. Separate Accounting
Required

Because the 401(k) plan will allow for pretax
contributions that are includible in income when distributed
(traditional and employer matched contributions) and contributions
made with after-tax income that will be distributed tax free (Roth
contributions), there must be separate accounts and separate
recordkeeping for the different types of contributions (Sec.
402A(b)(2)). This was further clarified to apply to the treatment of
separate accounts regarding automatic rollover rules for mandatory
distributions (Sec. 402A(d)(4)). In addition, gains, losses, and
other charges must be separately allocated on a reasonable and
consistent basis to the designated Roth account.

9. Only
Roth-to-Roth Rollovers

Whereas a traditional IRA may be
converted to a Roth IRA, there is no provision for converting a
pretax elective contribution account under a 401(k) to a designated
Roth account. A direct rollover of a distribution from a Roth 401(k)
may only be made to another Roth elective deferral account, such as
another Roth 401(k) or a Roth IRA (Sec. 402A(c)(3)(A)). Regs. Sec.
1.408A-10, Q&A-2, clarified that a rollover from a Roth 401(k)
to a Roth IRA may take place even if the individual is not eligible
to make regular or conversion contributions to a Roth IRA due to
income limitations

10. Set Up by Year End

The Roth
designation is a feature of a new or existing 401(k) plan. The plan
does not have to be modified before accepting Roth designated
moneys; however, the plan does need to be amended by the end of the
plan year (December 31 for calendar year plans) for contributions
made that year to be considered Roth designated. For example, funds
may be designated Roth on July 1, 2008, even if the Roth feature has
not been designated to the plan, as long as the plan is amended by
December 31, 2008 (Notice 2005-95).

Conclusion

The most
appropriate participants for the Roth designations are those that
would like to contribute to a Roth IRA for tax-free growth but are
unable to do so because of income limitations or those that would
like to contribute more than they are currently allowed. In general,
younger individuals saving for retirement and those who expect their
tax bracket to increase would benefit greatly from making Roth
designations. But the benefit will be realized only if the
designation is used, and 401(k) participants and employers will
certainly not adopt the designation if they are not familiar with
it.

EditorNotes:

Frank J. O’Connell Jr. is a
partner in Crowe Chizek in Oak Brook, IL.

Unless otherwise
noted, contributors are members of or associated with Crowe
Chizek.

Among CPA tax preparers, tax return preparation software generates often extensive and ardent discussion. To get through the rigors of tax season, they depend on their tax preparation software. Here’s how they rate the leading professional products.

The package includes final regulations, guidance on how to calculate W-2 wages, a safe-harbor rule for rental real estate businesses, and new proposed rules on the treatment of previously suspended losses.

Don’t get lost in the fog of legislative changes, developing tax issues, and newly evolving tax planning strategies. Tax Section membership will help you stay up to date and make your practice more efficient.